Spotlight - the window of opportunity

M&A and capital raising in mining & metals

  • Share

Availability of capital to undertake M&A

EY – capital availability to undertake mining M&A

Source: S&P Capital IQ, EY analysis.

×

There is a window of opportunity for those with confidence in the sector and access to longer-term, more patient capital.

These investors are looking to capitalize on:

  • Reduced competition for assets
  • Lower valuations
  • A continued flow of divestments from large cap producers

This window of opportunity will remain open until equity markets for the sector recover fully and while large cap producers remain cautious about investing.

Until then, those with access to patient private capital, including financial investors, will have a free run to take advantage of the current market conditions.

Availability of capital to undertake M&A
EY – capital availability to undertake mining M&A

 

Free cash flows have been squeezed over the last 18 months due to low earnings and a record level of investment, which reached its peak during 2012. Leverage consequently soared as companies took advantage of the favorable lending conditions to fund growth.

Reacting to this scenario, major producers are focused on:

  • Achieving cost-saving targets
  • Productivity improvements
  • Divestments
  • Scaling back capital expenditure
  • Pursuing only the top-tier projects and doing so incrementally

However, while conditions lend themselves to a return to investment, a complex capital allocation challenge exists where investment decisions are tougher than ever.

Companies are challenged to identify a unique strategy that sets them apart from their peers in an uncertain economic and commodity price environment, where returns can be marginal.

Balancing yield and capital appreciation

How does management achieve the right balance between short-term yield and long-term capital appreciation? The danger in seeking the former is that growth projects are snubbed at the detriment of long-term value. Encouragingly, analysis suggests the large cap producers, at least, should be able to satisfy both criteria, given expected improvements to cash flows.

Investors are presently being offered a better yield with higher dividends set against depressed share prices. While this is yet to flow through to greater investor sentiment, we do expect this to improve over time. Once confidence returns to the sector, companies will have more capacity to again focus on investing capital for growth.

This change in sentiment is not limited to producers. Development companies are preserving capital, optimizing project timetables and looking for a broader range of partners to de-risk the build-out.

The manner in which these companies are approaching capital markets is also changing, where wider pools of capital providers are being considered and capital is being stretched further. As this group of companies is increasingly looking to attract private equity type investment, they are approaching investment in a more disciplined manner, setting out milestones, increasing accountability and adjusting rewards.

The window will gradually close, not slam

The cyclical nature of the mining and metals industry is one of the key determinants of how long the window of opportunity will remain open for patient capital.

While forecasts are never conclusive, historical trends suggest larger producers will return to investments before long, although an imminent fight for assets with private capital looks unlikely.

As long as management’s primary focus is on cost optimization and driving up return on capital employed (ROCE), in the absence of a significant metals price jump, we are unlikely to see a return to large-scale M&A in the near term.

Shareholder pressure may alleviate over time, resulting in a situation where expectations realign to more modest levels of ROCE, incentivized by the prospect of higher yields.

In the interim, the time for those with a longer-term investment horizon to undertake M&A is now, where favorable valuations and reduced competition support an attractive acquisition environment.

However, the nature of this M&A is likely to differ from that historically where capital is likely to be preserved for opportunities that support a robust operational structure and margin-led growth rather than pure scale-led growth.